Decoding ETFs: A Beginner's Guide

Let's start from the beginning. Did you know that the first ETF in the world was created on the Toronto Stock Exchange (TIPs 35) in Canada in 1990. Three years later, State Street Global Investors launched the S&P 500 Trust ETF (SPDR or "spyder" for short; SPY), the first American ETF, which is also the largest fund in the world today, with more than $500 billion in assets. From one fund in 1993, the US market grew to 102 by 2002 and nearly 1,000 by the end of 2009.

The first two ETF funds in Europe saw the light of day exactly 10 years after the first ETF in Canada. Specifically, in April 2000, the first two ETFs (Euro Stoxx 50 and Stoxx Europe 50) were listed on the German stock exchange (Deutsche Boerse).

What are ETFs and how do they work?

ETFs or Exchange traded funds constitute funds that are traded on the stock exchange. ETFs, like mutual funds, collect capital from multiple investors managed by an independent third party for the purpose of collective financial investment.

But what do the funds represent? Funds are instruments designed to allow a wider range of investors into the financial markets. They issue shares that are available to the public for investment, where these shares represent a proportional part of the fund's total capital. When the resources from the sale of the shares are collected, the fund further places them in various investments. This concept of collective investment allows funds to invest capital in a variety of investment instruments, which ultimately results in a return for each investor corresponding to their invested capital.

Simply put, let's imagine the fund as a joint gift for your colleague's birthday. Let's say you agree with 9 colleagues that each of you will contribute 20 euros, thereby collecting 200 euros, enough for a weekend stay in a place that your colleague has been dreaming about for a long time. Each colleague makes their own contribution, and the fund, like the organizer, uses the capital to realize the wishes of the group. None of you could afford that gift alone, but by investing together, it becomes possible.

This is the essence of how funds work - they allow smaller investors access to investments in securities that might not be available to them on their own. A similar principle applies to ETFs. Thanks to ETF funds, you can get an investment with a well-distributed risk very cheaply, even for a small amount of money. There is little that can be compared to their effectiveness today.

The difference between ETFs and mutual funds

Although similar in nature, ETFs and mutual funds have their differences. The difference is in the method of buying and selling shares of the fund - with ETFs, this takes place on the stock exchange, while with mutual funds, it is done directly with the manager.

This difference brings several advantages. First, transaction costs are usually lower because they are paid by the exchange operator, not the fund manager, resulting in more favorable prices for investors. Second, ETFs allow trading within the day (like, for example, stocks), while shares in traditional mutual funds can only be bought and sold after the  trading day closes.

As we mentioned earlier, actively managed mutual funds have higher fees compared to ETFs that passively track the movements of indexes like the S&P 500.

But why is that? This difference in fees stems from the inherent costs of active management, which include fees for fund managers who try to outperform the market through active trading. You pay the manager and his team in the hope that he will outperform the market. However, it is important to note that although active managers tend to achieve better results, in the long run they are often outperformed (defeated) by passive strategies.

Source: Cgcashgroup

Analysis such as SPIVA (S&P Indices Versus Active) confirm this fact. Although specific results may vary between different editions of SPIVA, the same topic or points are repeated. One of these points is that actively managed funds have often underperformed their benchmarks, both over the short and long term. Furthermore, even when some funds have temporarily outperformed their benchmarks over a period of time, they have rarely maintained that outperformance in subsequent periods.

The data tells us that in Europe up to 98% of actively managed equity funds focused on global stocks failed to outperform the market over a ten-year period. This deep-seated condition points to the challenges active managers face in trying to justify their costs and consistently achieve above-average results. Therefore, investing in passive ETF strategies can be an attractive option for investors seeking transparency, lower costs, and long-term consistency. 

There are ETFs for every type of asset

Today, in 2024, there are more than 12,000 ETFs available worldwide, with around 600 different fund management companies and total assets of USD 12.25 trillion. ETFs are among the most popular investment tools for institutional and individual investors, typically accounting for between 26% and 30% of daily trading volume in the US in recent years.

In the FRED chart below, we can see how the popularity of ETFs has developed over the last 15 years or so, and how more and more people have recognized the advantages of predominantly index investing.

Source: Federal Reserve of St. Louis

Various types of ETFs are offered today, and the most popular among them are:

• Index ETFs: These are intended to track specific world indices. One of the most popular are S&P 500, Stoxx Europe 600 and MSCI world.
• Bond ETFs: These ETFs track various bond baskets.
• Commodity ETFs: Offer exposure to precious metals, commodities, or crude oil. There are various types of commodity ETFs that are exclusively focused on one type of commodity or group.
• Industry or Sector ETFs: These ETFs are narrowly focused on a single sector, such as pharmaceuticals, utilities or technology.
• Foreign Market ETFs: Allow you to easily access foreign markets.

How ETFs Track Their Underlying Assets

There are two basic types of replications: physical and synthetic. With a physical ETF, the ETF provider attempts to track the index by purchasing proportionally weighted index underlying assets, e.g. equities to reflect the movement of the index (full replication). In the case where the ETF provider buys only selected components of the index's assets, this is called sampling.

On the other hand, synthetic replication is mainly realized through the financial derivatives. An ETF provider may sign a contract with an investment bank to underwrite the return of a particular index in exchange for a fee. This method is known as synthetic (swap-based) replication. In the synthetic replication segment, progress has been made in the regulation and security of swap positions, resulting in an improved perception of synthetic ETFs in the investment context.

Diversification: A key benefit of ETFs

One of the key principles of successful investment is diversification. Instead of investing into a narrow range of securities or limiting yourself to only one asset class, it is advisable to build a diversified portfolio with a wide range of securities and assets. This approach protects your wealth: when one investment fails, others should compensate for the losses. ETFs are a great way to achieve diversification in your investment portfolio.

At Finax, we pay special attention to this aspect, and our portfolios are composed of over 13,000 securities distributed in as many as 92 countries. This diversity ensures maximum protection and reduces investment risk. As we often emphasize, this approach ensures that you don't put all your funds in the same basket, but spread them across thousands of baskets, so that if one basket takes a hit, you have many others where your funds are safe.

How can I invest in ETFs?

ETFs aim to offer investors a cost-effective route to diversified market exposure, not least because, as with other collectives, an investor can benefit from volume management and lower transaction costs than might be expected from each underlying security bought by an individual. Investors have access to diversified market exposure thanks to a single store. Most ETFs, though not all, also follow passive index-tracking strategies, which will be reflected in their management fee levels.

About 15 years ago, investing was much more complex, and the offer was limited and associated with high fees. However, today, thanks to digitization and globalization, investing has never been easier. At Finax, mere €10 is all it takes to achieve everything mentioned so far: diversification, low fees, while rebalancing your portfolio to ensure that the allocation matches your current level of risk and to maximize your return.

Therefore, now you have no more excuses or reasons to worry about your financial future. You have seen how you can start your investment journey even with minimum amount of capital and at the same time have the whole world in your portfolio. Therefore, sail into the investment waters with Finax, which will be your beacon and help you navigate through all the waves and currents and bring you safely to your goal.